How to Figure Your Annual Depreciation Allowance

jim kobzeff


Sept 29, 2015

Allowance for depreciation (known as cost recovery) is one of the biggest tax deduction benefits associated with real estate investing. Primarily because it's a "paper loss" the real estate investor can write off during each year of ownership without having to spend a dime out of pocket.

This is different than taking other legal tax deduction allowances like mortgage interest, for instance, because the IRS requires that the real estate investor actually pays out the mortgage interest to someone with hard dollars in order to write it off his or her income taxes. With depreciation allowance, however, no money ever exchanges hands. The investor claims the deduction on IRS form 4562.

Here's how it works.

The Internal Revenue Service rightfully concludes that any physical structure, regardless how grand and prestigious a building it may be when it's constructed, has a physical life of just so many years because it eventually will wear out, deteriorate, or become obsolescent.

As a result, the IRS concludes that the owner therefore is suffering a financial loss by owning the property and as such should be granted the benefit to recover the cost of that "loss" from his or her income taxes.

The real estate investor, therefore, can legally deduct an annual amount for depreciation as cost recovery from the cash flow generated by the asset during the past twelve months of ownership and therein lower his or her income tax liability for that past year.

The Concept

To do this the tax code classifies all investment real estate as either residential or commercial and has attributed a specific "useful life" to each for the purpose of arriving at the depreciation deduction it will recognize as allowable.

Useful Life

In essence, useful life represents the number of "useful" years that the IRS prescribes for rental property. But it is strictly used for tax purposes only according to the property's classification and does not necessarily imply the actual physical life expectancy of the physical asset.

Classification

The tax code classifies all investment real estate into one of two categories.

  1. Residential - This is rental property that derives all or nearly all of its income (i.e., about 80% or more) from dwelling units such as single-family homes, multi-families, apartment buildings, condos and so forth
  2. Non-Residential - This is rental property that derives its income from non-residential sources such as offices, retail space, strip centers, and industrial buildings. We commonly refer to it as commercial real estate.

In this case, the tax code currently regards the useful life for residential property as 27.5 years and nonresidential (or commercial) property as 39 years.

Limitations

Of course the IRS has limitations in place in order for real estate investors to take a deduction for rental property depreciation allowance.

  • A taxpayer must use the property in business or in an income-producing activity (an individual's personal residence does not qualify for depreciation deductions).
  • The property must have a determinable useful life of more than one year.
  • The property cannot be placed in service and disposed of in same year.
  • Cost recovery only applies to the physical structures of the property (called "improvements") and not to the land.
  • The depreciation begins when a taxpayer places property in service for the production of income and ceases to be depreciable when the taxpayer has fully recovered the property's cost or other basis, or when the taxpayer retires it from service, whichever happens first. In other words, real estate investors don't get the depreciation allowance for income property past its useful life nor after transferring title (e.g., the property is sold).

The Formulation

For this illustration we'll consider the formulation for the depreciation allowance taken annually during the holding period and ignore what the tax code calls the "mid-month convention", which only applies to the acquisition and sale years.

  1. Determine the depreciable basis. This essentially is the original value of the rental property less the value of the land.
  2. Divide the depreciable basis by what the current tax code attributes as the property's useful life.

Depreciable Basis / Useful Life = Annual Depreciation Allowance

Example

Say you purchased a duplex thirteen months ago for $500,000 of which $100,000 is the designated value of the land. What's your annual depreciation allowance?

Okay, first we must determine the depreciable basis by deducting the designated land value from the duplex's original value: $500,000 less 100,000 equals 400,000.

Next we determine the useful life attributable to the duplex by the tax code. Since most of its income is derived from dwelling units, this is a residential property and therefore has a useful life is 27.5 years. The result,

$400,000 / 27.5 = $14,545

Rule of Thumb

This is only intended to give you an idea about depreciation allowance. We purposely avoided other elements that could become part of the equation such as capitalized costs of acquisition and additions for the sake of simplicity. You should always consult a qualified tax person before making any real estate investment decisions.

So You Know

Annual depreciation allowance is one of sixty real estate calculations you can make with iCalculator. Check it out at iCalculator.

james kobzeff author

James Kobzeff
Jim is a former realtor with over thirty years real estate investment property experience. He is the developer of ProAPOD's investment real estate analysis software solutions.